Emerging markets equities have been on a tear this year. While the rally may still have some legs, the challenge now is how to gain the right exposure.

Up 25% year-to-date, emerging markets have been the best-performing region this year—but this rally has room to run. We at Morgan Stanley Wealth Management remain bullish because of growing global trade, better fundamentals, accommodative financial conditions and a weakening U.S. dollar. In addition, we see lower risk than in the past that emerging markets could succumb to a taper tantrum caused by the Federal Reserve’s tightening.

In fact, we believe that we may be entering a regime of emerging market (EM) outperformance, as these markets have lagged developed markets equities since the financial crisis 122% to 197%. We believe the time has come for the turn. In addition, Morgan Stanley’s Global Investment Committee has said in their seven-year strategic forecast that they also expect EM equities to outperform, with 7.5% annualized return versus developed market (DM) equities’ 5.5% annualized return.

The Growth Gap

Emerging markets typically do well when economic growth is accelerating and the growth gap between the emerging and developing worlds widen. The growth gap widened in the 2000s, leading to EM equities’ outperformance, followed by the gap narrowing from 2009 to 2015, when the developed markets outperformed.

Since then, the gap has widened, and EM equities have outperformed again. Currently, EM equities trade at a 25% discount to DM equities based on the price/earnings ratio, thus offering better value. With our sanguine view toward the emerging markets, the challenge now is how to best gain exposure. Many would choose an exchange-traded fund or mutual fund. However, we view emerging markets as a heterogeneous group and believe that it’s best to be selective. Additionally, as central banks move toward normalizing monetary policy, the correlations between EM markets are declining and country and stock selection matter more.

Furthermore, EM Asia has the highest concentration of high-growth economies, driven by demographics, domestic demand and corporate earnings. As for countries, we favor India, China, South Korea, Taiwan and Mexico. Exposure to these regions and countries can be obtained through specific exchange-traded funds.

EM exposure via DM companies. Another way to gain emerging market exposure is through DM multinationals that generate revenue in emerging markets. Here we prefer European to U.S. companies, as European firms generate more than 30% of revenues from emerging markets vs. less than 15% for U.S. companies. Also, European equities appear to trade at relatively cheaper valuations than U.S. equities and offer a higher dividend yield. Although a weaker dollar/stronger euro benefits U.S. multinationals and is negative for European multinationals, we believe that the stronger euro is ultimately a plus for European equities. Thus, to gain EM exposure, we prefer the opportunity set through European multinationals. Specifically, European beverage and auto companies stand to benefit most from EM exposure.

High-quality EM companies. The emerging markets contain a number of high-quality, world-class companies that offer compelling investment opportunities with increased portfolio diversification. We prefer those with greater exposure to domestic demand, sustainable competitive advantages, a strong management team and currently reasonable valuations. Within EM companies, we see opportunities in Indian banks, Chinese ecommerce and Mexican retailers.

Note: This article first appeared in the August 2017 edition of “On the Markets,” a publication of the Global Investment Committee, which is available on request. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.

Risk Considerations

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity.

Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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